Modigliani and Miller's Model(M&M)

?        Modigliani and Miller's Theory

?        Modigliani and Miller's Formula

?        AFM Exam Question for M&M Model: 201306Q1-a(1) 

M&M demonstrated that, ignoring tax, the use of debt simply transfers more risk to shareholders, and that this makes equity more expensive so that the use of debt does not reduce finance costs, ie does not reduce the WACC.

M&M then introduced the effect of corporation tax to demonstrate that if debt also saves corporation tax,，then this extra effect means that the WACC will fall. This suggests that a company should use as much debt finance as it can.

Modigliani and Miller's Formula

M&M’s formula for Ke of a geared company reflects the effects of using debt finance ie the benefit of the tax relief and the extra financial risk that it brings.

Formula provided

Ke= cost of equity of a geared company, Keⁱ= cost of equity in an ungeared company

Kd= cost of debt (pre-tax)

Vd, Ve= market value of debt and equity

An ungeared company with a cost of equity of 12% is considering adjusting its gearing by taking out a loan at 6% and using it to buy back equity. After the buyback the ratio of the market value of debt to the market value of equity will be 1:1. Corporation tax is 30%.

Required:

(a)   Calculate the new Ke’ after the buyback.

(b)   Calculate and comment on the WACC after the buyback.

(a)   Ke=12+(1-30%)×(12-6) ×1/1=12+4.2+16.2%

(b)   WACC=(0.5×16.2)+[0.5×0.6×(1-30%)]=8.1+2.1=10.2%

The use of debt will bring benefit to the company because the lower WACC will enable future investment to bring greater wealth to the company’s shareholders.